Warning: May Cause Munchies and Preclude Bankruptcy Relief

Posted by NCBRC - October 3, 2014

A Colorado Bankruptcy Court found that a debtor whose only non-social security income was generated through the marijuana industry could not avail himself of bankruptcy relief. In re Arenas,  — B.R. —-, 2014 WL 4288991 (Bankr. D. Colo. Aug. 28, 2014). The chapter 7 debtors’ income sources were $4,265.16 from Mr. Arenas’ marijuana growing business for which he was licensed under Colorado law, a lease with a marijuana dispensary, and $3,000.00 from his co-debtor wife’s social security disability benefits. Mr. Arenas’ marijuana-related business interests were legal under state law and illegal under the federal Controlled Substances Act.

The trustee moved to dismiss the debtors’ bankruptcy for cause under section 707(a) based on the reasoning set forth in In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012). Rent-Rite was a chapter 11 case in which the debtor operated a warehouse that it leased to a tenant who used it in furtherance of his marijuana operation. The court concluded that even though sale of marijuana was legal under state law, “a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aid of a Debtor whose activities constitute a continuing federal crime.”

Acknowledging that the legal principles in Rent-Rite would apply equally to their case, the Arenas debtors asked the court to reconsider that holding. The debtors also moved to convert their case to chapter 13.

The court found that because federal marijuana laws are generally enforced by state and local police, state legalization of marijuana has the practical effect of rendering the federal law toothless. However, just as states need not enforce federal laws against what is otherwise legal in the state, federal bankruptcy law does not have to administer what is illegal under federal law.

Because chapter 7 requires a trustee to take control of, and liquidate, a debtor’s assets, the court found that “administration of this case under chapter 7 is impossible without inextricably involving the Court and the Trustee in the Debtors’ ongoing criminal violation of the CSA.” If a chapter 7 case were permitted to go forward under this scenario in which the debtor’s only valuable asset is unreachable by the trustee, the debtors could retain the financial benefit of Mr. Arenas’ marijuana activities, while benefiting from discharge of their debts through bankruptcy. The court found that this paradox created “cause” for dismissal under section 707(a).

The same reasoning prevented the court from approving conversion of the case to chapter 13. “[T]heir reorganization would be funded from profits of an ongoing criminal activity under federal law and would necessarily involve the Chapter 13 Trustee in administering and distributing funds derived from the Debtors’ violation of the CSA.” Section 707(d), as explained in Marrama v. Citizens Bank, 549 U.S. 365 (2007), gives a debtor a right to convert only where the debtor “may be a debtor” under the new chapter. Where, as here, the debtors could not fund the plan in a manner that would not be in violation of federal drug laws, their chapter 13 plan would be in “objective” bad faith, despite the absence of any actual nefarious motive.

Citing Gonzales v. Raich, 545 U.S. 1 (2005), the court also rejected the debtors’ argument that the federal Controlled Substances Act violates the Tenth Amendment. In Gonzales, the Court held that the Commerce Clause authorizes the federal government to regulate marijuana-related activities in states in which such activities are otherwise legal.

The debtors have filed an appeal to the Bankruptcy Appellate Panel for the Tenth Circuit, Case No. 14-46.

Arenas Bankr. Colo. opinion

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